Friday, August 10, 2012

FSA's brilliant ideas to fix LIBOR

While the media has been focused on the LIBOR setting scandal, no one seems to be asking the question: why would banks want to contribute their LIBOR numbers at all? If you run a bank you have to pay your treasurer to make up a bunch of numbers every day and send them out to be scrutinized. Yes, it's multiple numbers - by currency, by maturity. The media, the regulators, and clients will all read your contributions and compare them to other banks. Chances are that once in a while your numbers will be considerably higher or lower than the average and you will be accused of wrongdoing. It's just the law of random numbers - sooner or later you'll be on the tail of the distribution.

Of course your treasurer can't be bothered with making up numbers daily, so she will delegate it to some junior folks. And you can only hope those junior employees don't have too many persuasive friends on the trading floor trading basis swaps. This is a serous headache. Most businesses want to get paid for their headaches. But LIBOR/EURIBOR is charity work - banks do it for free to get their name on the British Bankers Association (BBA) or the European Banking Federation (EBF) list. Makes them feel important. Tons of downside risk with no upside opportunity.

It is therefore likely that many banks will simply pull out of this exciting venture going forward, which could turn out to be a big embarrassment for BBA and EBF. So these organizations have been pushing regulators to force banks to submit the numbers and add more banks to the list. Make it the "cost of doing business". Seems the regulators may be receptive to that idea and are working on some "creative" solutions.

Reuters: - Until now, membership of the panel has been the preserve of a small group of banks, which volunteer daily estimates for the rates at which they would borrow different currencies for different periods to come up with a set of benchmarks.

But Mr. Wheatley [managing director of the Financial Services Authority] said providing quotes for LIBOR could become mandatory to widen the number of banks taking part and improve LIBOR's credibility.

But wait a minute. Requiring banks to make up numbers will not make LIBOR any more reliable than if the banks do it voluntarily. And adding more random number generators will not make the mean any more "accurate". But the FSA has a solution.

Reuters: - Other changes he suggested included basing LIBOR rates on actual trades rather than bank estimates. When there aren't changes for a specific rate — a particular problem for longer-term rates — rate setters could use "interpolation" based on the more frequently traded short-term rates.

Right. The only "frequently traded" rate is the overnight rate for most currencies. So the proposal is to have the three-month rate "interpolated" from the overnight rate? Maybe they mean "extrapolated"? Let's see now, we'll have some junior bank treasury employees sit around on a daily basis and try to draw a line from a single point, hoping other banks do it the same way to avoid "standing out" too much. And $500 trillion in contracts will settle based on these "interpolated" numbers. That's how you manage the global financial system - the FSA way.

Reuters: - Mr. Wheatley said supervision of LIBOR could be handled by a "college of supervisors" from across the world — a system common for cross-border banks — with Britain in the chair. This may not satisfy other regulators, however.

How could it possibly not satisfy other regulators? Here is an idea. Why not have Mr. Wheatley and the other bureaucrats at the FSA set the LIBOR rate? At least he would earn his salary payed by the UK taxpayer as opposed to spending his time coming up with such "meaningful" proposals. And Mr. Wheatley's guesswork on LIBOR maybe just as accurate as that of the banks.